There has been a divergence in the international market in the rate which will replace USD LIBOR when it is discontinued at the end of June next year. Given the significant investment in systems to calculate compounded in arrear near risk-free rates (RFRs) and market familiarity with those rates in multicurrency deals, compounded RFRs are still widely used. However, Term SOFR, a forward-looking screen rate that is commonly used in the US domestic market, is becoming more popular internationally. The release by the Loan Market Association (LMA) of an exposure draft investment grade facility agreement which uses Term SOFR, alongside compounded RFRs for other currencies and EURIBOR, simplifies the use of different reference rates for different currencies.
What is term SOFR?
- An economic concept, calculated using SOFR derivatives for each day that the New York Federal Reserve publishes SOFR, to provide a forward-looking market estimate of future overnight SOFR over a period. It is therefore conceptually similar to compounded SOFR, despite being a forwardlooking screen rate.
- Term RFRs generally have a relatively limited use case, but the regulatory consensus is that SOFR has a sufficiently large and liquid derivatives market to give comfort that Term SOFR calculated from it will be robust. • Published for one, three, six and 12 month tenors
- Published as a screen rate by both CME Group, whose rate has been endorsed in the US by the ARRC (the Alternative Reference Rates Committee), and more recently by ICE Benchmark Administration Limited. These two screen rates are calculated using a different methodology and will not necessarily be the same.
- It is available for use in calculations under licence in each case. One or two jurisdictions may have regulatory requirements which add complexity to the process of a lender acquiring a licence, which may be relevant in a widely-syndicated transaction.
- Since it is an economic concept, and is not directly representative of lenders' funding costs, it is not a straight replacement for LIBOR. This means that a credit adjustment spread (CAS) is likely to remain relevant, particularly on transition from LIBOR.
What are the main outstanding documentary issues?
The LMA produced an exposure draft document for use in developing markets transactions which contemplated the use of Term SOFR. In October this year, they published an investment grade facility agreement which was substantially the same in approach, and though neither document is yet in recommended form, the market seems to be adopting their suggested drafting to a large extent. There are, though, still a few issues to be negotiated on each deal.
Should we use a CAS?
Since Term SOFR is calculated using SOFR derivatives, despite the name no term funding or credit risk is priced into the rate and Term SOFR over a period is generally expected to be lower than USD LIBOR for the same tenor, in normal circumstances. Term SOFR is in this way conceptually similar to compounded RFRs and may need to be adjusted to cater for this marginal difference, particularly where loans are transitioning from LIBOR. The calculation of the adjustment spread itself is still a point for negotiation.
Often the ISDA CAS, published by Bloomberg Index Services Limited, has been used for ease: this is the five-year historical median difference between USD LIBOR and SOFR over a five-year lookback period from 5 March 2021. However, given that USD LIBOR has been lower than SOFR plus a CAS for some tenors, in some cases a CAS may not perform the function intended in adjusting SOFR to equate to LIBOR. Also, given the period of time that has elapsed since 5 March 2021, the rate fixed on that date may no longer be appropriate.
In new money deals, pricing is usually renegotiated to deal with the issue instead of having a tripartite interest rate, for both loans and linked swaps.
What if the screen rate is not available?
The LMA investment grade document uses a waterfall approach to determining the reference rate to be used, in a very similar way to the LIBOR screen rate waterfall, using an interpolated rate, shortened interest periods, and historic screen rates. They also have the option to fall back to a compounded reference rate, a central bank rate and, ultimately, lenders' cost of funds. ICE Term SOFR could be used as an interim fallback from CME Term SOFR, following the LMA drafting.
Stub interest periods
The shortest period for which there is a Term SOFR screen rate is one month. For interest periods shorter than one month, where no Term SOFR is available for the relevant interest rate, the waterfall would again be used. If the LMA drafting is followed, this would mean that the rate would be interpolated between overnight SOFR and one-month Term SOFR. Conceptually this is a little odd, but it seems to be an approach that the market is happy with.
Though there seems to be a general acceptance in the market that lenders no longer match fund, and therefore the concept of break costs may not be required (unless a bespoke concept of broken funding costs is required on a particular transaction), the point is not as well settled for Term SOFR loans as for compounded RFR loans. The corollary of not including break costs in compounded RFR loans is often a limit on prepayments; however, this may not be necessary where the calculation of accrued interest using a screen rate, rather than a compounding mechanism, is less complex.
The risk that the new reference rate is less than lenders' cost of funds is often still a point for negotiation. Since lenders no longer match fund, there are arguments for not including market disruption provisions, though they may be included with a higher threshold of lenders' commitments required as a trigger.
The rate to which the zero floor is applied, whether Term SOFR or Term SOFR + CAS will need to be considered on a case-by-case basis.
Term SOFR swaps are available, though their characteristics mean that they may be more expensive than compounded RFR swaps. Hedging a Term SOFR loan with a compounded RFR linked swap would increase the basis risk on the transaction, and may be less palatable where it is important that the hedging matches the loan.
Synthetic USD LIBOR is not a given
The Financial Conduct Authority issued a consultation in June 2022 in relation to whether any USD synthetic LIBOR rates will be published after USD LIBOR ceases to be representative on 30 June 2023. They have not published their course of action, at the time of writing, but regulatory pressure to transition to SOFR remains strong. The FCA has said that synthetic yen LIBOR will be discontinued at the end of 2022, and one and six-month sterling LIBOR will be discontinued at the end of March 2023, leaving only three-month synthetic sterling LIBOR, so any synthetic LIBOR rates are a short-term solution, at best.